Kancelaria Medius SA. (WSE:KME) outperformed the Diversified Support Services industry on the basis of its ROE – producing a higher 39.74% relative to the peer average of 10.48% over the past 12 months. While the impressive ratio tells us that KME has made significant profits from little equity capital, ROE doesn’t tell us if KME has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable KME’s ROE is. See our latest analysis for Kancelaria Medius
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Kancelaria Medius’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Kancelaria Medius’s cost of equity is 8.67%. This means Kancelaria Medius returns enough to cover its own cost of equity, with a buffer of 31.07%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
Dupont Formula
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Kancelaria Medius can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Kancelaria Medius’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 177.85%, meaning the above-average ratio is a result of a large amount of debt.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Kancelaria Medius’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Kancelaria Medius’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.